There is a fine line between stupid and clever

Summary:
There is a fine line between stupid and clever
Recently a loyal reader emailed me with a disarmingly simple question: is it better to invest small amounts every month, or in a large lump sum? What seems a narrow topic has broader implications.
The popular argument in favour of regular investment into shares — often called “cost averaging” — has been made by retail investment advisers many times. “Take advantage of their downs as well as their ups,” says one, so that “if you invest a fixed sum every month you will be able to buy more units when a fund’s value falls”.
To see how this cost averaging might work, consider a share that costs half the time and 0 the other half. Investing 0 a month returns 10 shares in each of the six months when it is cheap and five shares

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There is a fine line between stupid and clever

Recently a loyal reader emailed me with a disarmingly simple question: is it better to invest small amounts every month, or in a large lump sum? What seems a narrow topic has broader implications.

The popular argument in favour of regular investment into shares — often called “cost averaging” — has been made by retail investment advisers many times. “Take advantage of their downs as well as their ups,” says one, so that “if you invest a fixed sum every month you will be able to buy more units when a fund’s value falls”.

To see how this cost averaging might work, consider a share that costs $60 half the time and $120 the other half. Investing $600 a month returns 10 shares in each of the six months when it is cheap and five shares in each of the expensive months. At the end of the year, 90 shares have cost $7,200. The average cost per share is only $80, much closer to $60 than $120 and thus excellent value.

The argument is plausible, intuitive, and wrong — both in theory and when tested with hindsight against historical market data.

Here’s the problem with the theory: while it is unclear exactly how best to describe the fluctuations of share prices, they do not simply move up and down in the way my simple example describes. If they did, a far better approach would be to invest only when they cost $60, not when they cost $120.

A more realistic description of the stock market is that it follows a random walk with an upward drift. The random walk implies that we cannot expect prices to tend back towards some average. From any particular point there is no way to say in which direction they will lurch next. That means that we cannot expect that when a share is $120 it is likely to fall, and when it is $60 it is likely to rise.

The upward drift — the simple fact that share prices tend to rise over time — suggests that we should invest everything we plan to invest at the earliest opportunity. Drip-feeding delays profitable investment, and so costs money.

If theory is unkind to the cost-averaging principle, what about the historical evidence? We can ask, with hindsight, when investors with a large lump sum would have done better to drip it gradually into the market over the course of a year. The answer is unsurprising: drip-feeding has done better only when the market then fell, and since markets rise more often than they fall, lump-sum investing is a better bet. Cost averaging worked well in the last bear market, but, with access to that kind of hindsight, an even better strategy in a bear market is to wait until it is over.

Cost averaging, then, is wrong in theory and has not usually worked in practice.

It may, nevertheless, be excellent advice.

The simplest point in favour of drip-feeding is that it reflects the situation of a typical salaried investor. Purists will say that “cost averaging” should only be used to describe a deliberate strategy of delaying investment, but retail advisers often speak of the magic of cost averaging while praising regular investment. The magic may be illusory, but the benefits of regular investment are not.

Many of the empirical tests of cost averaging begin from the premise that an investor is sitting on some vast pile of cash, pondering whether to invest gradually or all at once. That is a pleasant dream to consider, and if you find yourself with a million dollars in your pocket then by all means invest promptly.

If you are nervous about risk, academic research suggests that drip feeding is not the most efficient way to reduce your risk. Better to keep a small portion of your wealth out of the stock market entirely.

But efficiency is a treacherous goal for an ordinary investor.

The strongest argument in favour of cost averaging is simply to ask ourselves what we are likely to do instead. The answer is not pretty. Researchers have found that retail investors tend to make two simple errors: they lose money by trading too much, and they tend to buy high and sell low. Without getting too technical, let me assure you that this is not the aim. If regular investments displace a Gordon Gekko complex, that is enough for me.

While markets do not swing back and forth with the metronomic predictability of my earlier illustration, they do fluctuate a lot, as we have seen in the past couple of weeks. That fluctuation is distressing for most people. If facile arguments for cost averaging reassure small investors and stop them from selling at the bottom, that is no bad thing.

Greg Davies, a behavioural finance expert at Oxford Risk, describes cost averaging as “deliberately doing something slightly inferior, to prevent the likelihood of something very inferior”. Just so. And it is worth looking for other areas where we might benefit from being guided by a slightly inferior rule of thumb — anything from “if it takes less than two minutes, do it immediately” to “never drink alone”. There are exceptions to these rules, but you may be better off just sticking to the rules.

As a wise man once said, it’s such a fine line between stupid and clever. Cost averaging seems clever, but we should recognise that its true value lies in not being stupid.

Tim is an economist, journalist and broadcaster. He is author of “Messy” and the million-selling “The Undercover Economist”, a senior columnist at the Financial Times, and the presenter of Radio 4’s “More or Less” and the iTunes-topping series “Fifty Things That Made the Modern Economy”. Tim has spoken at TED, PopTech and the Sydney Opera House and is a visiting fellow of Nuffield College, Oxford.